What’s the Market Going to Do Next?

Nobody can predict market behavior with any certainty, but we do think highly of the views held by the folks at Advisor Partners (AP), the firm that manages many of our clients’ assets. We had a conversation with Daniel Kern, president and CIO, and Gerard Cronin, portfolio manager, about the economy and their expectations of market behavior in the upcoming months.

Overview

Analysts estimate the US second-quarter growth rate to be about 3%, although some of that is likely to be activity that was postponed from the first quarter, when the weather was so terrible. The employment picture is improving, with unemployment insurance claims going down and limited job growth.

Many analysts, including those at AP, think that inflation is still under control and that the rate will be about 2% this year. Deflation is unlikely to be a near-term risk in the US because the Fed will move actively to prevent it, although it’s more of a concern in Europe.

There is ample liquidity in the US and most global markets, although it’s a bit tighter in Europe, Dan said. Central banks have injected a lot of cash into the world’s economies, interest rates are low all over the world, and capital markets are open. Dan said that all of this facilitates corporate growth, allowing companies to borrow capital or go public, Credit markets for individuals are opening up more, and banks are generally lending more.

Government austerity is no longer the headwind it has been for the last few years. This has a spillover effect into the private sector, where companies may find that more public infrastructure projects are coming up for bid. Most analysts also expect companies to start spending more on infrastructure and other capital expenditures, and industrial activity is expected to pick up also.

Equities

US equities have been doing well lately and AP has an “overweight” (larger-than-normal) allocation to them in the global asset allocation of portfolios it manages. Dan thinks that US large-cap equities are more likely to offer value in the near term than small-cap equities because the run-up in small-caps has raised their price-to-earnings (P/E) ratios significantly higher than large-cap ratios.

The performance of international equities has been lagging that of US equities recently, but the picture appears to be improving in developed countries, especially Europe. AP is gradually moving from an underweight to neutral allocation to stocks in international economies and sees more promise in actively managed small-cap funds than in large-caps.

Looking at equities in emerging markets (EM), Dan says that this market is more complicated now than it was when the EM economies mostly moved in tandem. Passive strategies worked well when “all boats rose together,” but the additional fees of active management may be justified when managers have a good eye for discriminating between the stronger and weaker EM economies. The diversification value provided by EM equities is still important, but AP is keeping its allocation to them smaller than usual until gross domestic product (GDP) in EM countries begins growing, natural resource production increases, and multinationals report better growth in the market.

Bonds

Interest rates in the US have been so low that investors have been putting more money into below-investment-grade bonds. Striking the right balance between risk and yield is always problematic, but Dan thinks that below-investment-grade bonds continue to offer a reasonable yield premium to Treasuries, are less vulnerable to interest-rate changes, and in the current reasonably benign environment, don’t appear overly risky. However, yields are already tightening and interest rates may not stay low. Both of those elements will change the risk/yield balance. Currently, AP is underweighting Treasuries in its portfolios and expects to continue to do so in the near term. Outside the US, bonds did well, especially in developed markets. There are pockets of value to be found in Europe and Asia. AP doesn’t think holding much EM debt is a good idea now.

Many analysts are more worried about interest rates than default risk in developed countries at this point, although emerging markets are more problematic. Active management for international bonds might be worth the additional fees now because active managers are more likely to be able to spot which bond issuers might default.

Sunnier with a chance of rain

So, the economy is looking better overall, but there are clouds on the horizon. These include

Policy mistakes could disrupt the global economy, especially how China handles its credit issues and transitioning economy and how Europe addresses banking reforms. There seems to be progress in both arenas.

A sharp slowdown in China’s growth rate would have ripples around the world, but China has proved to be creative in keeping growth going.

The Federal Reserve Board is tapering off the bond buying that it’s been doing to prop up the economy, but it appears to be doing so “in a very measured way,” Dan said.

Global hot spots could cause more damage to the world economy: Ukraine, South China Sea, the Sunni/Shiite conflict.

At this point, AP doesn’t regard any of these as immediate and severe dangers, but that could change.

If you’d like to find out how Accretive Wealth could help you with your investment portfolio, please call or e-mail us today at (925) 365-1533 or lifeplan@accretivewealth.com.